ch06

Chapter 6-1

Chapter 6-2

C H A P T E R C H A P T E R 66

ACCOUNTING AND THE ACCOUNTING AND THE

TIME VALUE OF MONEYTIME VALUE OF MONEY

Intermediate Accounting13th Edition

Kieso, Weygandt, and Warfield

Chapter 6-3

1.1. Identify accounting topics where the time value of money Identify accounting topics where the time value of money is relevant.is relevant.

2.2. Distinguish between simple and compound interest.Distinguish between simple and compound interest.

3.3. Use appropriate compound interest tables.Use appropriate compound interest tables.

4.4. Identify variables fundamental to solving interest Identify variables fundamental to solving interest problems.problems.

5.5. Solve future and present value of 1 problems.Solve future and present value of 1 problems.

6.6. Solve future value of ordinary and annuity due problems.Solve future value of ordinary and annuity due problems.

7.7. Solve present value of ordinary and annuity due problems.Solve present value of ordinary and annuity due problems.

8.8. Solve present value problems related to deferred Solve present value problems related to deferred annuities and bonds.annuities and bonds.

9.9. Apply expected cash flows to present value measurement.Apply expected cash flows to present value measurement.

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

Chapter 6-4

Future value Future value of a single of a single sumsum

Present value Present value of a single of a single sumsum

Solving for Solving for other other unknownsunknowns

Basic Time Basic Time Value Value

ConceptsConcepts

Single-Sum Single-Sum ProblemsProblems

AnnuitiesAnnuitiesMore More

Complex Complex SituationsSituations

Present Value Present Value MeasurementMeasurement

ApplicationsApplications

The nature of The nature of interestinterest

Simple interestSimple interest

Compound Compound interestinterest

Fundamental Fundamental variablesvariables

Future value Future value of ordinary of ordinary annuityannuity

Future value Future value of annuity dueof annuity due

Examples of Examples of FV of annuityFV of annuity

Present value Present value of ordinary of ordinary annuityannuity

Present value Present value of annuity dueof annuity due

Examples of Examples of PV of annuityPV of annuity

Deferred Deferred annuitiesannuities

Valuation of Valuation of long-term long-term bondsbonds

Effective-Effective-interest interest method of method of bond discount/ bond discount/ premium premium amortizationamortization

Choosing an Choosing an appropriate appropriate interest rateinterest rate

Expected cash Expected cash flow illustrationflow illustration

Accounting and the Time Value of Accounting and the Time Value of MoneyMoney

Chapter 6-5

In accounting (and finance), the phrase time

value of money indicates a relationship

between time and money—that a dollar

received today is worth more than a dollar

promised at some time in the future.

Basic Time Value ConceptsBasic Time Value ConceptsBasic Time Value ConceptsBasic Time Value Concepts

Time Value of Money

LO 1 Identify accounting topics where the time value of money is LO 1 Identify accounting topics where the time value of money is relevant.relevant.

Chapter 6-6

1. Notes

2. Leases

3. Pensions and Other Postretirement Benefits

4. Long-Term Assets

Applications to Accounting Topics:

5. Sinking Funds

6. Business Combinations

7. Disclosures

8. Installment Contracts

Chapter 6-7

Payment for the use of money.

Excess cash received or repaid over the amount borrowed (principal).

Variables involved in financing transaction:

1. Principal - Amount borrowed or invested.

2. Interest Rate - A percentage.

3. Time - The number of years or portion of a year that the principal is outstanding.

Nature of Interest

Chapter 6-8

Interest computed on the principal only.

LO 2 Distinguish between simple and compound interest.LO 2 Distinguish between simple and compound interest.

Simple Interest

Illustration: KC borrows $20,000 for 3 years at a rate of 7% per year. Compute the total interest to be paid for the 3 years.

Federal law requires the disclosure of interest rates on an annual basis in all contracts.

Interest = p x i x n

= $20,000 x .07 x 3

= $4,200

Total Total InterestInterest

Chapter 6-9

Simple Interest

Illustration: KC borrows $20,000 for 3 years at a rate of 7% per year. Compute the total interest to be paid for the 1 year.

= $20,000 x .07 x 1

= $1,400

Annual Annual InterestInterest

Chapter 6-10

Simple Interest

Illustration: On March 31, 2011, KC borrows $20,000 for 3 years at a rate of 7% per year. Compute the total interest to be paid for the year ended Dec. 31, 2011.

= $20,000 x .07 x 9/12

= $1,050

Partial Partial YearYear

Chapter 6-11 LO 2 Distinguish between simple and compound interest.LO 2 Distinguish between simple and compound interest.

Compound Interest

Computes interest on

the principal and

any interest earned that has not been paid or withdrawn.

Most business situations use compound interest.

Chapter 6-12

Illustration: Tomalczyk Company deposits $10,000 in the Last National Bank, where it will earn simple interest of 9% per year. It deposits another $10,000 in the First State Bank, where it will earn compound interest of 9% per year compounded annually. In both cases, Vasquez will not withdraw any interest until 3 years from the date of deposit.

Year 1 $10,000.00 x 9% $ 900.00 $ 10,900.00

Year 2 $10,900.00 x 9% $ 981.00 $ 11,881.00

Year 3 $11,881.00 x 9%$1,069.29 $ 12,950.29

Illustration 6-1Illustration 6-1Simple versus compound interest

Chapter 6-13 LO 3 Use appropriate compound interest tables.LO 3 Use appropriate compound interest tables.

Table 1 - Future Value of 1

Table 2 - Present Value of 1

Table 3 - Future Value of an Ordinary Annuity of 1

Table 4 - Present Value of an Ordinary Annuity of 1

Table 5 - Present Value of an Annuity Due of 1

Compound Interest Tables

Number of Periods = number of years x the number of compounding periods per year.

Compounding Period Interest Rate = annual rate divided by the number of compounding periods per year.

How much principal plus interest a dollar accumulates to at the end of each of five periods, at three different rates of compound interest.

Compound Interest

Illustration 6-Illustration 6-22

Compound Interest

Formula to determine the future value factor (FVF) for 1:

Where:

= future value factor for n periods at i interest n = number of periods i = rate of interest for a single period

FVF n,i

Compound Interest

Determine the number of periods by multiplying the number of years involved by the number of compounding periods per year.

Illustration 6-Illustration 6-44

A 9% annual interest compounded daily provides a 9.42% yield.

Effective Yield for a $10,000 investment.Illustration 6-5Illustration 6-5

Compound Interest

Chapter 6-18 LO 4 Identify variables fundamental to solving interest problems.LO 4 Identify variables fundamental to solving interest problems.

Rate of Interest

Number of Time Periods

Present Value

Future Value

Fundamental Variables to Compound Interest

Illustration 6-6Illustration 6-6

Chapter 6-19 LO 5 Solve future and present value of 1 problems.LO 5 Solve future and present value of 1 problems.

Single-Sum ProblemsSingle-Sum ProblemsSingle-Sum ProblemsSingle-Sum Problems

Unknown Future Value

Two Categories

Unknown Present Value

Chapter 6-20

The value at a future date of a given amount invested, assuming compound interest.

LO 5 Solve future and present value of 1 problems.LO 5 Solve future and present value of 1 problems.

FV = future valuePV = present value (principal or single sum) = future value factor for n periods at i interestFVF n,i

Where:

Future Value of a Single Sum

Future Value of a Single SumFuture Value of a Single SumFuture Value of a Single SumFuture Value of a Single Sum

Illustration: Bruegger Co. wants to determine the future value of $50,000 invested for 5 years compounded annually at an interest rate of 11%.

= $84,253

Illustration: Bruegger Co. wants to determine the future value of $50,000 invested for 5 years compounded annually at an interest rate of 11%.

What table do we use?

Alternate Calculati

Chapter 6-23

What factor do we use?

$50,000Present Value

Factor Future Value

x 1.68506 = $84,253

Future Value of a Single SumFuture Value of a Single SumFuture Value of a Single SumFuture Value of a Single SumAlternate Calculati

oni=11

Chapter 6-24

BE6-1: Chris Spear invested $15,000 today in a fund that earns 8% compounded annually. To what amount will the investment grow in 3 years?

0 1 2 3 4 5 6

Present Value $15,000

Future Value?

Present Value

Factor Future Value

$15,000 x 1.25971 = $18,896

i=8%n=3

Beginning Previous Year-EndYear Balance Rate Interest Balance Balance

1 15,000$ x 8% = 1,200 + 15,000 = 16,200$ 2 16,200 x 8% = 1,296 + 16,200 = 17,496 3 17,496 x 8% = 1,400 + 17,496 = 18,896

Beginning Previous Year-EndYear Balance Rate Interest Balance Balance

1 15,000$ x 8% = 1,200 + 15,000 = 16,200$ 2 16,200 x 8% = 1,296 + 16,200 = 17,496 3 17,496 x 8% = 1,400 + 17,496 = 18,896

BE6-1: Chris Spear invested $15,000 today in a fund that earns 8% compounded annually. To what amount will the investment grow in 3 years?

Chapter 6-27

BE6-1: Chris Spear invested $15,000 today in a fund that earns 8% compounded semiannually. To what amount will the investment grow in 3 years?

0 1 2 3 4 5 6

Present Value $15,000

Future Value?

Present Value

Factor Future Value

$15,000 x 1.26532 = $18,980

What factor?

i=4%n=6

Chapter 6-29

The value now of a given amount to be paid or received in the future, assuming compound interest.

Present Value of a Single Sum

Where:

FV = future valuePV = present value (principal or single sum) = present value factor for n periods at i interestPVF n,i

Present Value of a Single SumPresent Value of a Single SumPresent Value of a Single SumPresent Value of a Single Sum

Illustration: What is the present value of $84,253 to be received or paid in 5 years discounted at 11% compounded annually?

= $50,000

Chapter 6-31

Illustration: What is the present value of $84,253 to be received or paid in 5 years discounted at 11% compounded annually?

Alternate Calculati

Chapter 6-32

$84,253Future Value Factor Present

x .59345 = $50,000

What factor?

Chapter 6-33

BE6-2: Tony Bautista needs $25,000 in 4 years. What amount must he invest today if his investment earns 12% compounded annually?

0 1 2 3 4 5 6

Present Value?

Future Value $25,000

Chapter 6-34

x .63552 = $15,888

What factor?

Chapter 6-35

0 1 2 3 4 5 6

Present Value?

Future Value $25,000

BE6-2: Tony Bautista needs $25,000 in 4 years. What amount must he invest today if his investment earns 12% compounded quarterly?

Chapter 6-36

x .62317 = $15,579

i=3%n=16

Chapter 6-37

Solving for Other Unknowns

Example—Computation of the Number of Periods

The Village of Somonauk wants to accumulate $70,000 for the construction of a veterans monument in the town square. At the beginning of the current year, the Village deposited $47,811 in a memorial fund that earns 10% interest compounded annually. How many years will it take to accumulate $70,000 in the memorial fund?

Chapter 6-38

Using the future value factor of 1.46410, refer to Table 6-1 and read down the 10% column to find that factor in the 4-period

Chapter 6-39

Using the present value factor of .68301, refer to Table 6-2

and read down the 10% column to find that factor in the 4-

period row.

Chapter 6-40

Solving for Other Unknowns

Example—Computation of the Interest Rate

Chapter 6-41

Using the future value factor of 1.76234, refer to Table 6-1 and read across the 5-period row to

find the factor.

Chapter 6-42

Using the present value factor of .56743, refer to Table 6-2 and read across the 5-period

row to find the factor.

Chapter 6-43

AnnuitiesAnnuitiesAnnuitiesAnnuities

(1) Periodic payments or receipts (called rents) of the same amount,

(2) Same-length interval between such rents, and

(3) Compounding of interest once each interval.

Annuity requires:

LO 6 Solve future value of ordinary and annuity due problems.LO 6 Solve future value of ordinary and annuity due problems.

Ordinary annuity - rents occur at the end of each period.

Annuity Due - rents occur at the beginning of each period.

Two Type

Chapter 6-44 LO 6 Solve future value of ordinary and annuity due problems.LO 6 Solve future value of ordinary and annuity due problems.

Future Value of an Ordinary Annuity

Rents occur at the end of each period.

No interest during 1st period.

Present Value

2 3 4 5 6 7 8

$20,000

20,000 20,000 20,000 20,000 20,000 20,000 20,000

Future Value

Illustration: Assume that $1 is deposited at the end of each of 5 years (an ordinary annuity) and earns 12% interest compounded annually. Following is the computation of the future value, using the “future value of 1” table (Table 6-1) for each of the five $1 rents.

Future Value of an Ordinary AnnuityFuture Value of an Ordinary AnnuityFuture Value of an Ordinary AnnuityFuture Value of an Ordinary Annuity

Chapter 6-46

A formula provides a more efficient way of expressing the future value of an ordinary annuity of 1.

Where:

R = periodic rentFVF-OA = future value factor of an ordinary annuity i = rate of interest per period n = number of compounding periods

Chapter 6-47

Illustration: What is the future value of five $5,000 deposits made at the end of each of the next 5 years, earning interest of 12%?

= $31,764.25

Chapter 6-48

Illustration: What is the future value of five $5,000 deposits made at the end of each of the next 5 years, earning interest of 12%?

Illustration 6-19Illustration 6-19What table do we use?

Alternate Calculati

Chapter 6-49

$5,000Deposits Factor Present

x 6.35285 = $31,764

What factor?

Chapter 6-50

BE6-13: Bayou Inc. will deposit $30,000 in a 12% fund at the end of each year for 8 years beginning December 31, 2010. What amount will be in the fund immediately after the last deposit?

Present Value

2 3 4 5 6 7 8

$30,000

30,000 30,000 30,000 30,000 30,000 30,000 30,000

Future Value

Chapter 6-51

Deposit Factor Future Value

$30,000 x 12.29969 = $368,991

Future Value of an Annuity Due

Rents occur at the beginning of each period.

Interest will accumulate during 1st period.

Annuity Due has one more interest period than Ordinary Annuity.

Factor = multiply future value of an ordinary annuity factor by 1 plus the interest rate.

0 1 2 3 4 5 6 7 8

20,000 20,000 20,000 20,000 20,000 20,000 20,000$20,000

Future Value

Future Value of an Annuity DueFuture Value of an Annuity DueFuture Value of an Annuity DueFuture Value of an Annuity Due

Comparison of Ordinary Annuity with an Annuity Due

Chapter 6-54

Illustration: Assume that you plan to accumulate $14,000 for a down payment on a condominium apartment 5 years from now. For the next 5 years, you earn an annual return of 8% compounded semiannually. How much should you deposit at the end of each 6-month period?

R = $1,166.07

Computation of Rent

Chapter 6-55

Computation of Rent

$14,000= $ $1,166.0712.00611

Alternate

Calculation

Chapter 6-56

Illustration: Suppose that a company’s goal is to accumulate $117,332 by making periodic deposits of $20,000 at the end of each year, which will earn 8% compounded annually while accumulating. How many deposits must it make?

Computation of Number of Periodic Rents

5.86660

Chapter 6-57

Illustration: Mr. Goodwrench deposits $2,500 today in a savings account that earns 9% interest. He plans to deposit $2,500 every year for a total of 30 years. How much cash will Mr. Goodwrench accumulate in his retirement savings account, when he retires in 30 years?

Computation of Future Value

Chapter 6-58

Illustration: Bayou Inc. will deposit $20,000 in a 12% fund at the beginning of each year for 8 years beginning January 1, Year 1. What amount will be in the fund at the end of Year 8?

Present Value

2 3 4 5 6 7 8

$20,000

20,000 20,000 20,000 20,000 20,000 20,00020,000

Future Value

Chapter 6-59

Deposit Factor Future ValueLO 6 Solve future value of ordinary and annuity due problems.LO 6 Solve future value of ordinary and annuity due problems.

12.29969 x 1.12 = 13.775652

$20,000 x 13.775652= $275,513

Chapter 6-60 LO 7 Solve present value of ordinary and annuity due problems.LO 7 Solve present value of ordinary and annuity due problems.

Present Value of an Ordinary Annuity

Present value of a series of equal amounts to be withdrawn or received at equal intervals.

Periodic rents occur at the end of the period.

Present Value

2 3 4 19 20

$100,000

100,000

100,000. . . . .

100,000

Illustration: Assume that $1 is to be received at the end of each of 5 periods, as separate amounts, and earns 12% interest compounded annually.

Present Value of an Ordinary Present Value of an Ordinary AnnuityAnnuity

Chapter 6-62

A formula provides a more efficient way of expressing the present value of an ordinary annuity of 1.

Where:

LO 7 Solve present value of ordinary and annuity due problems.LO 7 Solve present value of ordinary and annuity due problems.

Chapter 6-63

Illustration: What is the present value of rental receipts of $6,000 each, to be received at the end of each of the next 5 years when discounted at 12%?

Chapter 6-64

Illustration: Jaime Yuen wins $2,000,000 in the state lottery. She will be paid $100,000 at the end of each year for the next 20 years. How much has she actually won? Assume an appropriate interest rate of 8%.

Present Value

2 3 4 19 20

$100,000

100,000

. . . . .

100,000

$100,000Receipts Factor Present

x 9.81815 = $981,815

Present Value of an Annuity Due

Present value of a series of equal amounts to be withdrawn or received at equal intervals.

Periodic rents occur at the beginning of the period.

Present Value

2 3 4 19 20

$100,000

100,000

100,000 . . . . .

100,000

Chapter 6-67

Present Value of an Annuity DuePresent Value of an Annuity DuePresent Value of an Annuity DuePresent Value of an Annuity Due

Comparison of Ordinary Annuity with an Annuity Due

Chapter 6-68

Illustration: Space Odyssey, Inc., rents a communications satellite for 4 years with annual rental payments of $4.8 million to be made at the beginning of each year. If therelevant annual interest rate is 11%, what is the present value of the rental obligations?

Chapter 6-69

Illustration: Jaime Yuen wins $2,000,000 in the state lottery. She will be paid $100,000 at the beginning of each year for the next 20 years. How much has she actually won? Assume an appropriate interest rate of 8%.

Present Value

2 3 4 19 20

$100,000

100,000

100,000 . . . . .

100,000

$100,000Receipts Factor Present

x 10.60360 = $1,060,360

Chapter 6-71

Illustration: Assume you receive a statement from MasterCard with a balance due of $528.77. You may pay it off in 12 equal monthly payments of $50 each, with the first payment due one month from now. What rate of interest would you be paying?

Computation of Interest Rate

Referring to Table 6-4 and reading across the 12-period row, you find 10.57534 in the 2% column. Since 2% is a monthly rate, the nominal annual rate of interest is 24% (12 x 2%). The effective annual rate is 26.82413% [(1 + .02)12 - 1].

Chapter 6-72 LO 8 Solve present value problems related to deferred annuities LO 8 Solve present value problems related to deferred annuities

and bonds.and bonds.

Rents begin after a specified number of periods.

Future Value - Calculation same as the future value of an annuity not deferred.

Present Value - Must recognize the interest that accrues during the deferral period.

More Complex SituationsMore Complex SituationsMore Complex SituationsMore Complex Situations

0 1 2 3 4 19 20

100,000

100,000. . . . .

Future ValuePresent Value

Deferred Annuities

Two Cash Flows:

Periodic interest payments (annuity).

Principal paid at maturity (single-sum).

0 1 2 3 4 9 10

140,000

$140,000 . . . . .

140,000

2,000,000

Valuation of Long-Term Bonds

More Complex SituationsMore Complex SituationsMore Complex SituationsMore Complex Situations

Chapter 6-74

BE6-15: Clancey Inc. issues $2,000,000 of 7% bonds due in 10 years with interest payable at year-end. The current market rate of interest for bonds of similar risk is 8%. What amount will Clancey receive when it issues the bonds?

Present Value

2 3 4 9 10

140,000

$140,000 . . . . .

140,000

Valuation of Long-Term BondsValuation of Long-Term BondsValuation of Long-Term BondsValuation of Long-Term Bonds

2,140,000

LO 8 Solve present value problems related to deferred annuities LO 8 Solve present value problems related to deferred annuities and bonds.and bonds.

$140,000 x 6.71008 = $939,411

Interest Payment

Factor Present Value

PV of Interest

$2,000,000 x .46319 = $926,380

Principal Factor Present Value

PV of Principal

Chapter 6-77

BE6-15: Clancey Inc. issues $2,000,000 of 7% bonds due in 10 years with interest payable at year-end.

Present value of Interest $939,411

Present value of Principal 926,380

Bond current market value $1,865,791

Account Title Debit Credit

Cash 1,865,791

Discount on Bonds 134,209

Bonds payable 2,000,000

Chapter 6-78

Cash Bond Carrying Interest Interest Discount Value

Date Paid Expense Amortization of Bonds1/1/10 1,865,791

12/31/10 140,000 149,263 9,263 1,875,054 12/31/11 140,000 150,004 10,004 1,885,059 12/31/12 140,000 150,805 10,805 1,895,863 12/31/13 140,000 151,669 11,669 1,907,532 12/31/14 140,000 152,603 12,603 1,920,135 12/31/15 140,000 153,611 13,611 1,933,746 12/31/16 140,000 154,700 14,700 1,948,445 12/31/17 140,000 155,876 15,876 1,964,321 12/31/18 140,000 157,146 17,146 1,981,467 12/31/19 140,000 158,533 * 18,533 2,000,000

* rounding

Schedule of Bond Discount Amortization10-Year, 7% Bonds Sold to Yield 8%

BE6-15:

Chapter 6-79

Concepts Statement No. 7 introduces an expected cash flow approach that uses a range of cash flows and incorporates the probabilities of those cash flows.

Choosing an Appropriate Interest Rate

Three Components of Interest:

Pure Rate

Expected Inflation Rate

Credit Risk Rate

LO 9 Apply expected cash flows to present value measurement.LO 9 Apply expected cash flows to present value measurement.

Present Value MeasurementPresent Value MeasurementPresent Value MeasurementPresent Value Measurement

Risk-free rate of return. FASB states a company should discount expected cash flows by the risk-free rate of return.

Chapter 6-80

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